“[The] wave of disinflation continues to be much more prevalent than previously expected. The latest inflation readings (both the Producer and Consumer Price Indices) show deflationary forces still at work. The core reading for PPI declined in May to 1.6% while CPI remained flat at 1.7%. However, PPI and CPI mask the true economic pressures on the consumer as wage growth remains stagnant, economic production is stalling and price pressures are falling. More importantly, there are downward pressures on the most economically sensitive commodities such as oil, copper and lumber which indicate weaker levels of economic output both domestically and globally. The battle against the deflationary economic pressures has been what the Federal Reserve has been forced to fight since the financial crisis.”

The Fed’s biggest fear has always been the fear of deflation as it erodes economic prosperity over the longer term. Furthermore, outright deflation is a very hard cycle to break as it becomes embedded in the consumer psychology. In yesterday’s FOMC statement Bernanke repeatedly issued assurances that in the longer term view that inflationary pressures will rise to the Federal Reserves goal of 2%. However, as I showed in “Fed’s Projections: Myth Vs. Reality”even their own projections of inflation have been significantly lowered for 2013 from 1.65% in March to just 1.15% in June.

However, Bill Gross, picked up on this idea yesterday during his interview on CNBC stating:

“I think the Chairman is almost deathly afraid and we have witnessed in speeches going back five or 10 years on the part of the chairman in terms of the helicopter speech and the reference not only to the depression but to the lost decades in Japan. I think he is deathly afraid of deflation. As we meander back and forth around the 1% level, I would suggest that the chairman, to the extent that he perhaps has a limited time left in terms of being the Chairman, that he would guide the committee towards not only an unemployment rate which has been emphasized in terms of the Q&A but also towards a higher inflation target, which is really a target. It’s not something in terms of a cap, but the inflation target of 2% and for the next year or two, 2.5% has been specifically delineated in terms of that. It’s a target. Those who think it is a cap and we are 1% below the cap and therefore the Fed doesn’t care about it, I think the chairman told us the Fed does care about it and the closer we get to 2%, the better as far as he’s concerned.”

In other words, this low inflation we’re getting is not a good thing and the Fed wants higher inflation. Low inflation as discussed drags on economic growth, wages, living standards. Of course, this is why we also saw the Fed guide down their estimates for economic growth this year from 2.6% to 2.5% even though the majority of economists estimates are still considerably higher than that. The question that no one has yet to answer is exactly where that economic growth is going to come from given the fact that we are seeing year over year declines in the rate of growth as discussed in “3 Reasons Stocks May Stumble Despite Fed.”

“The economy is currently pushing a third straight quarter of sub-2% growth with the Federal Reserve discussing taking away a major support for the economy. The extraction of liquidity from the system will stem the forward pull of future consumption, which has come at the expense of higher credit balances and lower personal savings rates for consumers, leading to weaker rates of economic growth.”

The other problem of low, and falling, inflationary pressures is the effect on interest rates. This is what Gross had to say on the issue:

“I think they are missing the influence on inflation that obviously the chairman has considered and perhaps the committee as well. There was a question and Q&A that basically said, Mr. Chairman, if we are down at 1% inflation and it doesn’t rise, then real interest rates are in a quandary to which you have limited flexibility, and he said, I agree completely with the premise of your question.”

That limited flexibility, as we have discussed numerous times as of late, is the same“Liquidity Trap” that Japan has been locked into for more than a decade. Low rates of inflation, or disinflation, keeps the Federal Reserve from raising interest rates. If the Fed tries to raise the overnight lending rate it slows the economy. The chart below shows the Fed Funds rate as compared to GDP. Notice that each time the Fed Funds rate rises it coincides with a decline in economic growth. Exactly how is the Fed supposed to remove their “accommodative policy” when the economy is growing at a sub-par rate. Furthermore, given that we are already 48 months into the current post-recession expansion, we are closer to the next economic contraction rather than an expansionary boom.

Therefore, while the Fed says they expect to keep accommodative policy in place through 2014, the reality is that without an inflationary push caused by a strengthening economy it is likely they will forced to keep rates suppressed for much longer than intended. Monetary policy is not a driver of economic growth and there are huge assumptions being made that by the end of 2013 the effects of the “Fiscal Cliff” deal will have passed. The problem is that higher tax rates are here to stay, which drags on consumption, and the impact of the(Un)Affordable Care Act are just beginning to be felt as implementation begins with exchanges in October and the full brunt of the ACA hits in 2014. Businesses are already rapidly downsizing staff, cutting hours and shifting full-time labor to temporary and part-time to reduce the impact of higher health care costs on profits.

I agree with Gross’s sentiment on the outlook for the economy in the months ahead:

“We think the chairman and the Fed are taking a very much of a cyclical type of view. He blames lower growth on fiscal austerity and expects towards the end of the year once that is gone, all of the sudden the economy will be growing at 3%. He blames housing prices moving up on homeowners that simply like higher home prices as opposed to emphasizing the mortgage rate, which is really what has provided the lift in the first place. To a certain extent his driving analogy, which he talked about pulling back on the accelerator, I think he might be driving in a fog. I think the Fed itself may be driving in a fog. To think that is a cyclical as opposed to a structural problem in terms of our economy. I simply think and PIMCO thinks that real growth to lower unemployment below 7% is a long shot over the next 6, 12, 18 months.”

Bill is absolutely correct in that the current problem with the economy is a structural one. This is why the Fed’s own growth projections continue to decline from one meeting to the next as the onslaught of misguided fiscal policies, increased regulations and higher taxes erodes economic prosperity.

About The Author

Lance Roberts – Host of Streettalk Live

After having been in the investing world for more than 25 years from private banking and investment management to private and venture capital; Lance has pretty much “been there and done that” at one point or another. His common sense approach has appealed to audiences for over a decade and continues to grow each and every week.

Lance is also the Chief Editor of the X-Report, a weekly subscriber based-newsletter that is distributed nationwide. The newsletter covers economic, political and market topics as they relate to the management portfolios. A daily financial blog, audio and video’s also keep members informed of the day’s events and how it impacts your money.

Lance’s investment strategies and knowledge have been featured on Fox 26, CNBC, Fox Business News and Fox News. He has been quoted by a litany of publications from the Wall Street Journal, Reuters, The Washington Post all the way to TheStreet.com as well as on several of the nation’s biggest financial blogs such as the Pragmatic Capitalist, Zero Hedge and Seeking Alpha.